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Under the Margin Rules, swap dealers and major swap participants that do not have a prudential regulator (Covered Swap Entities, or CSEs) would be required to collect and post initial margin for uncleared swaps with financial end users with material swaps exposure (MSE). Initial margin must be collected and posted beginning on or before the business day after execution of a new swap and on each business day thereafter, until the swap is terminated or expires. The proposed language in the Margin Rules does not expressly state whether initial margin would be transferred once daily or on an intraday basis. Intraday transfer of margin would be a substantial change to market practice and increase the operational burden on existing collateral management systems for many financial end users. Certain industry groups have requested that the CFTC clarify that the transfer of margin would only occur once daily based on the prior day’s pricing.

Initial Margin – Eligible Collateral

Eligible collateral for initial margin includes a broad range of collateral, including cash denominated in US dollars, several enumerated major currencies and the currency in which payments under the relevant swap are required to be made. Commonly posted collateral such as US Treasuries or GSE debt or asset-backed securities are also permitted. Less commonly used collateral types such as certain publicly traded equities and gold are also permitted. However, initial margin may not consist of a security that is issued by (i) the party pledging the security of an affiliate of that party or (ii) a bank holding company, a savings and loan holding company, a foreign bank, a depository institution, a market intermediary, a company that would be any of the foregoing if it were organized under the laws of the US or any state, or an affiliate of any of the foregoing entities.

Initial Margin – Threshold and Minimum Transfer Amount

A CSE would not be required to collect initial margin to the extent that the initial margin that would be posted to the CSE and its affiliates by the financial end user and its affiliates is under $65 million. A minimum transfer amount of $650,000 would also apply, although it is somewhat unclear from the proposed language whether this amount applies across both initial and variation margin. ISDA has asked for clarification from the CFTC on this point and requested that the minimum transfer amount apply to each of IM and VM separately.

Variation Margin – Requirement and Timing

Subject to the minimum transfer amount, CSEs would be required to collect and post variation margin from financial end users. Unlike the initial margin requirement, this requirement applies to all financial end users irrespective of whether the entity has MSE. Variation margin must be collected or posted beginning on or before the business day after execution of a new swap and on each business day thereafter, until the swap is terminated or expires. As with the initial margin, the proposed language does not expressly make clear whether the CFTC contemplates the transfer of margin occurring on an intraday basis.

Variation Margin – Eligible Collateral

The Margin Rules limit eligible collateral for variation margin to cash, denominated in US dollars or in the “the currency in which payment obligations under the swap are required to be settled”, the determination of which would require a CSE to “consider the entirety of the contractual obligation”. The Margin Rules are less than clear on what the “entirety of the contractual obligation” means and unfortunately standard ISDA terms such as contractual currency, base currency, or termination currency do not have clear corollaries under the Margin Rules. Further muddying the waters, under Basel III leverage ratio rules the BIS defined “currency of settlement” as “any currency of settlement specified in the derivative contract, governing qualifying master netting agreement or the credit support annex to the qualifying master netting agreement.”

The limit of variation margin to cash also deviates significantly from the EU proposed technical standards for uncleared swaps margin, which does not restrict variation margin to cash. The cash restriction goes against the grain of common market practice of permitting highly liquid securities such as US Treasuries, subject to appropriate haircuts. The requirement could also require the liquidation of investments for certain businesses that must stay fully invested in securities or that do not carry large cash positions, such as asset managers or insurance companies. This could introduce tracking errors and other risks. Further, the restriction of variation margin to cash could potentially cause financial end users to turn to the US Treasury repo markets (which some market observers have said are increasingly illiquid) in order to “transform” their US Treasuries into cash, which implicates potential term mismatches and hence the possibility of forced sales in stressed market conditions.

As noted above, the Margin Rules provide for a minimum transfer amount of $650,000, although the application of this amount across initial margin or variation margin is not entirely clear.

What Valuation Percentage for the Mouse?

The various types of eligible collateral for initial margin would be subject to standardized haircuts, ranging from ranging from zero, in the case of cash in the same currency as the swap obligations, to 25 percent for certain equities. An additional 8 percent is imposed where “the currency of the swap obligation differs from that of the collateral asset”. The use of a model to calculate haircuts not permitted.

Not a Small World After All

As noted above, the EU regulators’ proposal permits non-cash assets to be posted as variation margin. There are several other notable differences between the EU and US proposed rules. For instance, the EU proposal imposes concentration limits on certain types of collateral, which is a significant change from market practice. In addition to highlighting these cross-border differences, future updates will also address issues such as the segregation of initial margin with a third party and the calculation of margin using a model versus a standardized table.

To close out with another Disney quote, “times and conditions change so rapidly that we must keep our aim constantly focused on the future.” The Margin Rules are indeed in a state of flux but we expect that the various proposals set out by regulators will converge to some extent over the next several months as they hammer out final rules, although it remains to be seen to what degree. Developments are worth monitoring given the operational and economic impact they will have on financial end users, as well as the lead time many entities will need in order to implement appropriate changes to existing practices.

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